Identifying the firm’s characteristics affecting the choice of inventory valuation methods

The economic evaluation of the procurement and inventory functions of a given firm depends, in part, on the method or methods used in the valuation of the various types of inventories common to most going concerns. And yet, very little is known about the reasons for the selection of the various methods, beyond tax considerations for U.S. firms. This paper is intended as one step toward closing this gap by examining the choice behaviour of firms in a country such as Canada, whose restrictive tax laws remove taxes as the distinguishing valuation criterion. To that effect, the various methods are classified into two categories, depending upon whether the method is intended to increase income (e.g., FIFO) or have a negligible effect on income (e.g., Average). Financial and operating characteristics of firms from the well-known political visibility and contracting and monitoring hypotheses are identified in an effort to determine if these properties are germane in explaining the choice of inventory method. The present results support the political visibility hypothesis, whereby firms larger in size are more likely to reduce exposure by avoiding the selection of income increasing methods. The authors conclude with comments on the applicability of the results to firms from other countries, of particular import in light of the recent impetus of international accounting bodies toward the harmonization of accounting standards.